Using Your Tax Refund for Retirement Financial Planning

The tax filing deadline was delayed for three months in 2020 due to the coronavirus pandemic. As a result, many of those who filed their taxes in July have recently received their income tax refunds. A tax refund can feel like a windfall, and many people choose to spend windfalls on something fun or frivolous. However, you may want to put your refund to work towards your retirement financial planning goals.

In 2020, there is good reason to rethink how you spend your refund. Coronavirus has changed the way we live, and accordingly, the way we spend. Whereas you might have been tempted to spend your tax refund check on travel, dining out, sports tickets, or new clothing, those options might not be as attractive this year (if they are available at all).

Quarantine has caused many of us to reexamine our choices and make decisions to enhance our financial security. That’s why now is the perfect time to take that income tax refund and apply it to retirement planning.

Making the Best Use of Your Income Tax Refund

Remember that your IRS tax refund and Ohio income tax refund are not really a windfall; it’s money that you earned, and of which your employer withheld more than needed to pay your taxes. Thinking of your refund as money you worked hard for may make you less inclined to use it for something that won’t give you a long-term benefit.

Once you’ve committed to using those funds to strengthen your financial future, what should you do? Given that the average tax refund in 2019 was $2,869, this isn’t a trivial question. A wise decision today could yield a significant benefit when you retire.

Fund an Individual Retirement Account

One option is choosing to fund an individual retirement account, or IRA. A traditional IRA is funded with pretax dollars, and distributions from the account are taxed as income when you take them in the future. In contrast, a Roth IRA is funded with income on which you have already paid income tax. Investments in a Roth IRA grow tax-free. That means when you finally withdraw funds from a Roth, you don’t pay income tax on them.

Which option you choose should depend on your current and anticipated tax brackets. If you expect that your current tax bracket is higher than it will be when you retire, it makes sense to use a traditional IRA. If you expect your tax bracket to be higher in retirement, a Roth IRA may make more sense.

Whether you choose a traditional or Roth IRA, contribution limits are $6,000 for individuals who are less than 50 years old. If you are 50 or older, you can contribute $7,000. Self-employed individuals can contribute to a simplified employee pension (SEP) IRA, which permits contributions of up to 25% of net earnings up to $57,000 this year.

Max Out 401(k) Contributions

If your employer offers you a 401(k), check to see whether you are making the maximum allowable contribution. The maximum contribution in 2020 is $19,500. If you are not maxing out your contribution to your 401(k), you are missing out—especially if your employer matches part of your contribution, as many employers do. In other words, for every dollar you contribute up to your employer’s match limit, your account increases by two dollars.

Contributions to your 401(k) come directly out of your paycheck, so you will need to increase the amount of your contribution (or contact human resources about starting one). You can use your tax refund to make up for the amount of money that has been taken out of your check—or better yet, use it to save for retirement in some other way, such as setting it aside in emergency savings.

Beef Up Your Health Savings Account

Similarly, you can apply money that has come back to you through a tax refund to your health savings account (HSA). If you wonder how an HSA, which you use to help pay medical expenses on a high-deductible health care plan, fits into retirement planning, you’re in for a pleasant surprise.

Money you put into an HSA doesn’t need to be used by the end of the year (unlike Flex Spending Accounts). That money can stay in the HSA for years, accumulating interest. When you withdraw it, the money will not be taxed. Furthermore, you, not your employer, own your HSA. That means, if you change jobs, the account is easily portable.

Even better: unlike an IRA or 401(k), there are no required minimum distributions from an HSA. You can leave money in there accumulating interest as long as you please (although you can no longer make contributions to your HSA after age 65). And while HSAs are intended to be used for medical expenses, after age 65, the funds can be used for certain non-medical expenses and for corrective lenses, hearing aids, and dental devices. The 2020 contribution limit is $3,550 for individuals, and $7,100 for families.

Using your tax refund to bolster your retirement savings could be the start of a good habit—and in future years, you may decide to reduce the size of your refund by reducing withholding from your paycheck, and instead have contributions made directly to your retirement plans.

If you have further questions about retirement financial planning, please contact Gudorf Law Group to schedule a consultation.